Analysis & Opinion

LONDON Oct 14 (Reuters) - Europe's banks are on the verge
of being recapitalised under an attempt to halt a euro zone debt
crisis and restore confidence in the battered sector.

European leaders appear sure to agree a plan, although
details have not yet been finalised.

Here are the key issues:

WHY DO BANKS NEED CAPITAL?

Politicians want to make banks strong enough to absorb
losses on Greek government bonds and other sovereign debt, and
still have enough capital to withstand a possible recession
without taxpayers being called on for emergency rescues.

HOW HIGH WILL THEY RAISE THE BAR?

Past attempts to shore up the industry have failed, so there
are growing calls for Europe to hit banks hard, "bazooka-style"
as did U.S. Treasury Secretary Hank Paulson in 2008.

Banks are likely to be told they need a minimum core Tier 1
capital ratio of 9 percent after being "stress tested" to
estimate their losses from a two-year recession and on Greek,
Irish, Italian, Portuguese and Spanish government bonds. The
level has not yet been finalised, however, and could be 7
percent or 8 percent.

The new standard is likely to be based on a tighter
definition of capital than used now, although not as strict as
full force Basel III rules. Those rules will be phased in from
2013 until 2019.

HOW MUCH CAPITAL WILL BE NEEDED?

It depends on the minimum level that's set. Banks would have
a shortfall of about 260 billion euros if the minimum level is 9
percent, based on previous stress test data and current bond
prices. But that level would drop to 100 billion euros if the
bar is set at 7 percent.

Banks have sold assets, shrunk loan books and retained
earnings this year, which will reduce the amount needed.
Including some of those measures, analysts at Citi estimated
banks will need 64 billion euros to reach a minimum capital
ratio of 7 percent and 216 billion euros if it is 9 percent.

WHAT'S THE TIME FRAME?

Banks are expected to be given about 6 months to raise the
capital, EU officials said.

Proposals are expected to be agreed by EU ministers at a
meeting on Oct. 23.

WHO WILL NEED CASH?

Royal Bank of Scotland , UniCredit ,
Deutsche Bank , BNP Paribas , Societe
Generale , Commerzbank and Barclays
would all each need over 10 billion euros based on end-December
data provided by all banks and a minimum capital ratio of 9
percent.

They would need far less capital, or none at all, if a
level of 7 percent was set. But even at that lower level
Greece's six main banks -- including National Bank of Greece , Eurobank EFG and ATEbank -- could
need more than 30 billion euros.

Some banks are better positioned than shown in the
end-December data, however. Deutsche Bank and RBS, for example,
have substantially reduced their loan books and sovereign
holdings, reducing their needs.

WHERE WILL CASH COME FROM?

Private investors appear reluctant to pump cash into banks.
Some national champions like Deutsche Bank or BNP Paribas may be
able to raise money privately, potentially from Middle East or
Asian sovereign wealth funds. But national governments are
likely to have to provide the bulk of cash, with the new euro
zone rescue fund EFSF available as a last resort.

CAN CAPITAL IMPROVE IN OTHER WAYS?

By reducing assets banks are improving their capital ratios.
The recap plan is likely to increase pressure on banks to cut
back on lending that uses a lot of capital, such as asset
finance, unsecured consumer finance, trade finance, syndicated
lending and some business lending.

Banks could also be told to cut pay for staff and dividends
for investors to preserve cash.

WILL THE RECAPS HURT THE ECONOMY?

Very possibly. Banks are already cutting back on loans, and
a rapid deleveraging could damage economic recovery efforts.

A potential way to limit the threat to the economy would be
to give banks a tight deadline to raise capital.

"If given time, banks may attempt to shrink their balance
sheets as a means to satisfying the new higher capital
requirements. This could lead to a long-lasting credit crunch as
banks restrict the availability of credit to the wider economy,"
said Michael Symonds, credit analyst for financials at Daiwa.

WHO IS RUNNING THE TEST?

The health check is being coordinated by the European
Banking Authority (EBA), an EU body made up of banking
supervisors from all the bloc's 27 member states. It sets the
data banks must provide, but it's up to national regulators to
make sure this happens. The EU's executive European Commission
and the European Central Bank also play a role. The decision on
capital ratios will be made by EU finance ministers.

HASN'T A "STRESS TEST" ALREADY BEEN DONE?

The EBA tested 90 lenders in July in a bid to shore up
confidence. It gave investors a fuller picture of the euro zone
sovereign debt held by each of the lenders, but only eight banks
failed, needing just 2.5 billion euros.

The July test did not impose losses on government bonds held
in banking books and was widely criticised as too soft.

WHAT TYPE OF CAPITAL WILL BE ISSUED?

Officials are still discussing the type of capital banks
should top up with. Banks in France and elsewhere want to be
able to use loss-absorbing hybrid instruments, like preference
shares that can convert into equity if a bank hits trouble. A
more traditional recapitalisation would provide good quality
pure equity, but would be more dilutive and costly for
shareholders.

"At one extreme we could see cheap, non equity Tier 1
capital injections that would prove positive, at the other,
extremely dilutive equity issuance at well below book value,"
said Simon Samuels, analyst at Barclays Capital.

IS THERE A LEGAL RISK?

German banks say forced recapitalisations need a legal basis
which doesn't exist yet. They don't regard it as emergency case
(unlike 2008) that could justify a violation of property rights.
"You can expect dozens of lawsuits, if you push ahead with these
plans," a senior German banker said.

WHAT'S THE IMPACT ON NATIONAL FINANCES?

A capital shortfall of about 100 billion euros would equate
to 0.7 percent of the expected GDP across EU countries, and a
260 billion euro hole would represent about 2 percent of GDP.

If Greece is forced to foot the recap bill for its bank it
would likely push its debt-to-GDP ratio to more than 170
percent, from 157 percent. Although Spain and Italy could need
to pump substantially more into their banks, financing a recap
would only add 1 percent to their respective debt-to-GDP levels.

WILL A BANK RECAP BE ENOUGH?

Even a "bazooka" of a recapitalisation is likely to fail if
it is not accompanied by support for bank funding and a plan to
tackle sovereign problems. Bankers would like to see the ECB
offer longer 2-3 year funding support for banks, fearful that a
funding squeeze will become a major problem if it lasts into
next year.

The leaders of Germany and France have promised the bank
recap will be part of a package of measures set out by a Nov.
3-4 meeting of G20 countries.